Borrowing money for your business

All businesses borrow. They need cash for operations, and they need cash to invest in assets so they can build the business. Businesses can get the cash by they need by making a profit. However this may not be enough for growth.

Generally speaking, businesses borrow for one of three basic reasons. They need money to:

• Get started
• Grow
• Smooth out cash flow

When you started your business, you may have borrowed from family or friends. You may have used your credit cards. It could be that your business is a professional services business, and you were able to start small with just a few clients, and it really did not take much money to get started. Perhaps you turned your hobby into a business. Now you’ve reached the point that you need some money to get to the next level. Maybe you are an attorney and you are ready to hire a paralegal. Maybe you need a new lathe for your woodworking shop, or a new delivery van for the catering business. What do you do?

Good news! Even though you have heard all of the bad news about tight credit, there are plenty of things you can do to make it easier to borrow money. There are only two things you have to know.

1. Know yourself and your business.
2. Know your banker.

Know yourself and your business
You need to know about yourself and your business for two reasons. You need to be able to make good plans, and you need to be able to present those plans to whoever is going to lend you money. Give your CPA and bookkeeper a call and get a copy of your most recent financial statements. While you are at it, get copies of the previous few years. Look at everything and not just the P&L. If you don’t understand financial ratios, ask your CPA to explain them. The ratios are tools that you can use (and your lender will use) to evaluate the relationship between your debt and your assets, how much debt service you can handle, how you manage your cash flow, and whether your business is profitable. If you are a sole proprietor or a partnership, you will also want to review your personal financial situation. If you are not sure how to prepare your own personal financial statements, ask your CPA or bookkeeper for help. You should expect to pay a fee for these professional services, but trying to save a little in the beginning could cost you later.

 Once you understand your current situation, you can start working on the future. If you put together a business plan when you started your business, then this part should be easy. All you have to do is update your plan. If you don’t already have a business plan, then develop one. You can do this yourself. There are guides and templates available in many places. You can purchase planning software. You can also ask your CPA for assistance. The Small Business Administration provides a template. Another place to look for help is the Service Corps of Retired Executives (SCORE). This is a link to their template gallery.

However you develop your plan, it will contain these basic parts.

• Summary
• Overview of the business
• Analysis of the market
• Description of products
• Organization and management
• Marketing and sales plan
• Financial details

With a good understanding of your business and a business plan, you will be prepared to get to know your banker.

Know your banker
What does it mean to know your banker? In this case it means a few things. Some of them may not be possible right away because they take time. Some of them you can do immediately.

• Develop a relationship with the bank and with the people in it.
• Get to know everything your bank can do for you.
• Understand what your banker needs from you.

Develop a relationship with the bank and with the people in it
This should be obvious. Remember the movie, It’s a Wonderful Life. Think about the contrast between George Bailey at the Bailey Building and Loan Association and Mr. Potter. Find a bank that wants to get to know you and your business. Figure out who the George Bailey’s in your community might be, and avoid the Mr. Potters.

The other part of this is, once you find your version of George Bailey, you need to be a loyal customer. The bank will not want a relationship with you unless you demonstrate that you want a relationship with it. You should do most of your business with your new bank. You should also try to do it in person. When you walk in the door, you want the people in the bank to recognize you. Loyal customers are as important to your bank as they are to your business.

Get to know everything your bank can do for you
Many business people simply cannot imagine the range of services available at even the smallest community bank or credit union. Most people know about checking and savings accounts. They know about money market accounts and CDs. People know about loans such as mortgages, auto loans, and personal loans. However, did you know that many banks also provide merchant services? Did you know that your bank could help you install an ATM in your store for customers? Did you know that your bank can probably set up a lockbox arrangement so that customer payments can go directly to the bank and your account? Did you know that your bank can probably help with cash management tools such as zero balance accounts? If you need access to cash, did you know you could set up a line of credit instead of borrowing with a term loan? If you take the time to get to know all of the products and services your bank offers you might discover some new ways of managing your cash.

Understand what your banker needs from you
The simplest description of banking is that banks take the money deposited by some customers and lend it to other customers. They pay interest on deposits, and they charge interest on loans. They make money when the interest they charge is greater than the interest they pay. They lose money when customers do not pay back their loans. This means that your banker needs you to deposit money. Your banker also needs you to borrow money and pay it back. If you want to borrow money, you have to make the case that you will do just that.

That is why your first steps were getting your financial statements together and developing your business plan. You will need your financial statements and business plan to make your case. You will typically need the current year and the previous two or three years. Ideally your financial statements will demonstrate that you are solvent and have appropriate liquidity. They may also show how you handle payables and receivables. In short, the statements will explain your current situation and your history. If the statements reveal any serious flaws in your operations, be prepared to explain them.

Your business plan will tell the story that you hope will unfold. You will describe your company and your customers. Your plan will describe your products and why customers will buy them. It will explain your marketing and sales plans. Finally, your plan will make clear how you will use the money you borrow. This is the most important part because it will also explain exactly how you expect to pay the money back.

Financial statements and your business

Many small businesses operate on a cash basis, and the extent of their financial reporting is a monthly bank statement. At the end of the year, they pull all of their receipts together and group them so that they can complete their tax forms. That is a tough way to run a business because it is difficult for business owners to keep track of their financial position without good financial statements.

Why do you need financial statements?
Financial statements tell the story of a business. Income statements tell the story over time. Balance sheets tell the story at a point in time. Business owners want to know if they are making a profit and if they are going keep making a profit. Financial statements can help answer those questions. At some time or another, business owners will want to tell this story to others as well.

• Investors
• Suppliers
• Customers

Investors want to know if they are going to be paid back. Suppliers want to know if you will be around as a customer. If you are, how they want to know how big a customer you might be, and they want to know if you can afford to pay for their goods. Customers want to know if you are going to remain in business. If they buy products from you, they want to know that you will be able to stand behind them. If you provide some sort of professional service, they want to know that they will be able to go to you in the future.

Why not have financial statements?
Some small business owners have the misperception that it is too difficult or too expensive to maintain the records necessary to produce financial statements. Fortunately, keeping good financial records is actually fairly simple and not very expensive. Business owners can use spreadsheets such as Microsoft Excel, or they can use bookkeeping programs such as QuickBooks. Templates are available for spreadsheet users. Businesses that opt for bookkeeping software will even find that the software grows with them. The cost of these programs can be under a couple of hundred dollars. Business owners can also hire bookkeepers to do the work for them. This is also less expensive than many business owners realize, and having organized records and financial statements will reduce the cost of tax preparation. It can also make it easier to obtain financing.

Basic Statements
However you keep your records, you should produce these statements.

• Balance Sheet: This is a snapshot of short-term and long-term assets and liabilities.
• Income Statement: This is commonly called a P&L or profit and loss statement. It begins with revenue and then shows the effect of various expenses and ends with net income.
• Statement of Cash Flows: This is a description of how cash flowed in and out of your business, and it describes generally where money came from and how it was used in terms of operating, investing, or financing activities.
• Statement of Retained Earnings: This is a statement showing the accumulated earnings of a business.

Financial ratios
Once you have your financial statements in hand, you can review them. A few of the common ratios typically used to evaluate businesses are listed below. The list is far from complete. For example it does not include activity measures such as conversion periods or turnover ratios.

Measuring profit
Gross profit margin: This is a measure of how much of your income can go towards overhead and profit.

Gross Profit / Net Sales

or

(Net Sales – Cost of Goods Sold) / Net Sales

Operating margin: This tells you the profitablity of your core business.

Operating Income / Net Sales

or

(Operating Revenues – Operating Expeneses) / Net Sales

Measuring Liquidity
Current ratio: This is a measure of your ability to pay short-term debt.

Current Assets / Current Liabilities

Quick ratio or "Acid Test:" This is a more stringent variation of the current ratio. The Acid Test compares current assets net of inventory to current liabilities.

Evaluating Debt
Debt to assets ratio: This measures how much you rely on borrowing to finance operations.

Total Liabilities / Total Assets

Times interest earned or Interest coverage: This ratio measures the relationship between your income and your interest expense.

Net income / Interest Expense

Debt service coverage: This ratio shows the relationship between your operating income and your debt service expense.

Net Operating Income / Debt Service